Prof.

Fei DING
The Hong Kong University of Science and Technology

ECON 2123: Macroeconomics

FINANCIAL MARKETS
PREVIOUSLY …

Ch3: The Goods Market

LEARNING OBJECTIVES
 Understand sources and determinants of demand from decomposition of GDP.
 Define and derive the short run equilibrium output using two approaches.
 Describe effects of fiscal policy on equilibrium output, and its limitations.

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 Ch4: Financial Markets

LEARNING OBJECTIVES
Explain factors that determine the demand for money and write down the
money demand function.
 Define and derive equilibrium interest rate in the financial markets.
 Describe roles of banks and understand how the supply and demand of money
change with and without the presence of banks.

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FEDERAL RESERVE CUTS RATES BY
HALF PERCENTAGE POINT TO
COMBAT VIRUS FEAR
CENTRAL BANK LOWERS FEDERAL-FUNDS
RATE RANGE TO 1% TO 1.25% IN ITS
FIRST BETWEEN-MEETING MOVE SINCE
THE FINANCIAL CRISIS
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QUANTITATIVE EASING (QE)
QE1, QE2, and QE3
The expression "QE2" became a "ubiquitous nickname" in 2010, usually used to
refer to a second round of quantitative easing by central banks in the United
States. Retrospectively, the round of quantitative easing preceding QE2 may be
called "QE1". Similarly, "QE3" refers to the third round of quantitative easing
following QE2.
QE3 was announced on September 13, 2012. In an 11-to-1 vote, the Federal
Reserve decided to launch a new $40 billion a month, open-ended, bond
purchasing program; to continue until at least mid-2015. According to
NASDAQ.com, this is effectively a stimulus program which allows the Federal
Reserve to print $40 billion dollars a month for an unlimited amount of
time. Ratings firm Egan-Jones said it believes the Fed’s decision “will hurt the
U.S. economy and, by extension, credit quality.” As a result the firm once again
slashed the U.S. bond rating bringing it down to AA-. Federal Reserve chairman
Ben Bernanke acknowledged concerns about inflation.
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THINGS TO THINK ABOUT…
 What’s the relation between interest rate and overall
condition of the economy?

 We live in Hong Kong, why do we care about US rate?

 What are the impacts of the Fed’s decision to cut the

interest rate, on US economy and on HK economy?

 What are QEs? Why are they used to fight recession?

How do they differ from a rate cut?

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FINANCIAL MARKETS OVERVIEW

 Financial markets trade financial assets.

 What assets? Stocks, bonds, indices, futures, etc.,
and money (cash and checks).
 Why trade? Hope for return (interests & capital
gains).
 Money is special because
 Use for transactions – cannot pay for lunch with
stocks and bonds!
 No (or close to zero) return.

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 ~Zero interests
MONEY Easy transactions
A type of wealth
Self-sufficiency
Without Money
Barter economy

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MONEY VS. OTHER FINANCIAL ASSETS

 Money is the medium of

exchange, but has zero return.
 Other assets have higher returns,
but cannot be used to pay bills.
 Costly to convert into money
(transaction costs).

The ease with which money is converted into other things –

goods and services – is sometimes called money’s liquidity.
Money is the most liquid asset of all.

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MONEY – THE MOST LIQUID OF ALL

 There are two types of money.

 Cash/currency: coins and bills
 Checkable deposits: checking accounts at banks
and financial institutions
 Money or liquidity available in the market is
measured by
 M1 = cash + checkable deposits
 There are M2 (near money), M3 (near, near money),
etc.
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THE DEMAND FOR MONEY

 Money vs. Bond (a simplification)

 Group all other financial assets together  bonds: positive
interest rate i > 0, but cannot be used for transactions.
 How to divide your wealth between money and bonds?

 Trade-off return and liquidity!

 Higher level of transactions  more money
 Higher interest rate on bonds  more bonds

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THE DEMAND FOR MONEY
M d  $Y L(i)

 Increases proportionally with nominal income ($Y) – captures
transaction purpose of money (and taken as given for now)
 Suppose real income is unchanged but prices double leading to a
doubling of nominal income. We need to hold twice as much cash to
buy the same consumption baskets.
 Hyperinflation – super high inflation under which people must carry lots
of money, but real income is unchanged.

 Decreases with the interest rate, described by the function

L(i) – captures the opportunity cost of money.
 Hold less money and put more into bonds as i increases.
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Hyperinflation is defined as inflation that exceeds 50 percent
per month, which is just over 1% a day.

Eventually, when costs become too great with hyperinflation,

the money loses its role as store of value, unit of account and
medium of exchange. Bartering or using commodity money
becomes prevalent.

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14
THE DEMAND FOR MONEY – GRAPH

M d  $YL(i )
( )

Figure 4 - 1
The Demand for Money

For a given level of nominal

income, a lower interest rate
increases the demand for
money. At a given interest
rate, an increase in nominal
income shifts the demand
for money to the right.

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MONEY MARKET EQUILIBRIUM

 Money demand (Md) = Money supply (Ms)

 Who supplies money?
 Currency/cash: central banks
 HK  Hong Kong Monetary Authority (HKMA) (limited
role)
 US  Federal Reserve Banks (the Fed)
 Euro Zone  European Central Bank (ECB)
 China  People’s bank of China (PBOC)
 Checkable deposits: commercial banks
 Assume money supply Ms = currency (for now).
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MONEY MARKET EQUILIBRIUM
 Let the central bank’s supply of money = M.
 Assume constant supply, independent of interest rate, or
price, or income.
 The equilibrium in financial markets becomes
M  $Y L(i)
 This equilibrium is called the LM relation.
 L  liquidity – how easily an asset can be exchanged for
money.
 M  money – the most liquid of all assets
 LM relation  demand for liquidity = supply of money
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MONEY MARKET EQUILIBRIUM

Figure 4 - 2
The Determination of
the Interest Rate
The interest rate must be
such that the supply of
M  $Y L(i)
money (which is
independent of the interest
rate) is equal to the
demand for money (which
does depend on the
interest rate).

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MONEY MARKET EQUILIBRIUM

Figure 4 - 3
The Effects of an Increase
in Nominal Income on the M  $Y L(i)
Interest Rate
An increase in nominal income
leads to an increase in the
interest rate.

$Y ↑ → transaction ↑ → Md ↑
(at any i) → money demand
curve shifts to the right.

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HOW DOES MARKET BALANCE ITSELF?
Hold money vs. hold bond
 Our usual way of thinking
 $1  $1, interest on money is 0.
 $1  $(1+i), interest on bond is i.
 The way that works in reality
 Money: $100 gets you $100 in the future.
 Bond: $p gets you $100 in the future.
 What’s the relation between p and i?
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BOND PRICE AND YIELD

 Bond issuer is a borrower, promises a certain payment

at a certain time (maturity date).
 Current price directly determines the return on the
bond.
 Example of a 1-year T-bill issued by US government,
with a promised payment of $100:
$100  $ PB $100
i  $ PB 
$ PB 1 i

 Higher price lowers the return i, and vice versa.

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HOW DOES MARKET BALANCE ITSELF?
At the current interest rate, suppose the supply
of money is less than the demand for money.
Given this information, we know that:
1) the price of bonds will tend to increase.

2) the price of bonds will tend to fall.

3) production equals demand.

4) the goods market is also in equilibrium.

5) the supply of bonds also equals the demand

for bonds.
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MONETARY POLICY

 Ms is a straight line, what does it mean?

 Given, constant, exogenous
 The central bank chooses Ms as a policy tool to achieve a
target interest rate i.
 In practice, first choose i  adjust Ms to achieve that i.
 Open market operations (OMO): buying or selling
bonds by the central bank to change Ms.
 Buying bonds: increase Ms  expansionary policy
 Selling bonds: decrease Ms  contractionary policy

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MONEY MARKET EQUILIBRIUM

Figure 4 - 4 Ms'
The Effects of an Increase
in the Money Supply on the
Interest Rate M  $Y L(i)
An increase in the
supply of money leads
to a decrease in the
interest rate.

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MONETARY POLICY

Suppose nominal
income increases and
that the central bank
wants to keep the
interest rate unchanged.
What monetary policy
should it use?

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OPEN MARKET OPERATIONS
Figure 4 - 5
The Balance Sheet of the
Central Bank and the
Effects of an Expansionary
Open Market Operation
Open market operations
lead to equal changes in
assets and liabilities.

The assets of the central

bank are the bonds it holds.
The liabilities are the stock of
money in the economy. An
open market operation in which
the central bank buys bonds
and issues money increases
both assets and liabilities by
the same amount.
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OPEN MARKET OPERATIONS
OMO is a simple demand-supply reaction.
 Expansionary
 Central bank buys bonds  bond price ↑  interest rate ↓
 Balance sheet shows ↑ assets & liabilities  increase
money supply.
 Contractionary
 Central bank sells bonds  bond price ↓  interest rate ↑
 Balance sheet shows ↓ assets & liabilities  decrease
money supply.
Optional Reading: Hong Kong version of OMO
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MONETARY POLICY – SUMMARY
 Government’s fiscal policy influences the goods
market; central bank’s monetary policy influences the
financial market.
 Central bank chooses i by adjusting Ms.
 Increasing money supply too much may lead to
overheating/inflation in the medium and long run.
 Preventing “super-inflation” is the goal for many
central banks as well.
 What should the CB do to keep inflation under control?

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REFRESH

The money demand curve will shift to the right

when which of the following occurs?
1) a reduction in the interest rate
2) an increase in the money supply
3) an increase in income
4) all of the above
5) none of the above

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REFRESH

The money demand curve will shift to the left

when which of the following occurs?
1) a reduction in the interest rate

2) an increase in the interest rate

3) an open market sale of bonds by the central

bank
4) an increase in income

5) none of the above

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INTEREST RATE – CAVEATS
 We assumed one interest rate i, but in real world,
many rates.
 Treasury bills (T-bills) mature in 1 year or less.
 Treasury notes (T-notes) mature in 2-10 years.
 Treasury bonds (T-bonds) mature 20-30 years.
 Time deposits, money market savings account, etc.
 The central bank can, through open market
operations, change the short-term interest rate.
 QE vs. OMO
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THE MONEY MARKET – SUMMARY
 Interest rate i
 Price or conversion ratio of current vs. future consumptions
 Determined by demand and supply of money
 So far, only focus on currency/cash controlled by the
central bank through OMO.
 But M1 = currency/cash + checkable deposits.
 Checkable deposits are supplied by (private) banks.
 Can central bank still control i?

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WHAT BANKS DO
 Financial intermediaries: receive (borrow) funds from some and
provide (lend) to others.
 Deposits: liabilities of banks
 Loans, bonds, other assets: assets of banks
 Subject to regulations because of the risk involved.
 Credit risk: What if the loans cannot be repaid?
 Liquidity risk: What if the loans cannot be called back when I need the
money?
 Reserve ratio: % of deposits that must be kept as “reserve”
~10% in the US
 The rest: loans, bonds, interbank loans, etc.

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A RUN ON A BANK OF EAST ASIA BRANCH IN HONG
KONG, CAUSED BY "MALICIOUS RUMOURS" IN 2008.

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Bank Runs

Rumors that a bank is not doing well and some loans will not
be repaid, will lead people to close their accounts at that bank.
If enough people do so, the bank will run out of reserves—a
bank run.

To avoid bank runs, the U.S. government provides federal

deposit insurance.

An alternative solution is narrow banking, which would

restrict banks to holding liquid, safe, government bonds, such
as T-bills.

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WHAT BANKS DO

Figure 4 - 6
The Balance Sheet of Banks
and the Balance Sheet of
the Central Bank, Revisited

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OMO – BALANCE SHEET ANALYSIS
Central bank bought $10,000 bond from nonbank.
Central bank Nonbank (the public)
assets liabilities assets liabilities
bonds currency bonds -$10,000
+$10,000 (in circulation) currency (or cash)
+$10,000 +$10,000

Central bank bought $10,000 bond from a commercial bank.

Central bank Commercial bank
assets liabilities assets liabilities
bonds reserves bonds -$10,000
+$10,000 +$10,000 reserves +$10,000
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WHAT BANKS DO – MONEY MULTIPLIER EFFECT
 Without banks, central bank money = money supply.
 With banks, central bank money < money supply, because
reserve is only a fraction of total checkable deposits.
 Example: $100 central bank money gets deposited, with 10% reserve
 1st round: Bank A receives $100 deposit, at most $90 can be lent out.
(checkable deposit +$100)
 2nd round: The $90 loan gets deposited in bank B, at most $81 can be
lent out. (checkable deposit +$90)
 3rd round: The $81 loan gets deposited in bank C, at most $72.9 can be
lent out. (checkable deposit +$81) And so on, and so on…
 M1 = 100+90+81+72.9+… = 100/0.1 = 1000
 Equilibrium: money demand = money supply = central bank
money × money multiplier
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CENTRAL BANK MONEY: DEMAND AND SUPPLY
 Demand for central bank money = currency + reserves
 Supply of central bank money is controlled by the central
bank.
 The equilibrium interest rate is such that the demand and
the supply of central bank money are equal.

Figure 4-A1 Determinants of the Demand and the Supply of Central Bank Money

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SEE YOU NEXT TIME 

 Assigned reading:
 Textbook Chap. 4 (4-3, 4-4, and appendix optional
but need to know the materials from lecture slides)

 6th edition textbook Chap. 5 (for next time)

 Problem set 2 will be posted on CANVAS.

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